It is that time of the year – with tax season comes retirement account contribution season!
The most popular retirement account of the current decade is the Roth IRA. It offers tax-free growth, tax-free withdrawals after age 59.5, and no minimum distribution requirements. Unlike traditional IRAs, Roth’s are funded with after-tax dollars. There is no tax deduction for contributing. Evaluating whether to contribute to a pre-tax or Roth IRA is a common exercise. A prevalent misconception is choosing a pre-tax account is the best option. This is mostly because the investor expects that his tax rate will decline in retirement. However, NerdWallet’s Arielle O’Shea and Jonathan Todd published a study from which they concluded the opposite. They found that individuals who contribute the maximum amount annually were better off utilizing a Roth IRA in a vast majority of tax scenarios. Further, when you consider that Roth IRAs have no required minimum distributions and offer flexibility to save for education expenses, the benefits are superior.
Sounds like a great idea, what is the catch?
Unfortunately, the IRS sets an income phase-out for Roth contributions. In 2019, a single filer’s income phase-out starts at $122,000 of Modified Adjusted Gross Income (MAGI). For joint filers, the phase-out begins at $193,000 (contributions are disallowed if MAGI exceeds $137,000 for single filers and $203,000 for married couples, respectively). The phase-out ranges were slightly less in 2018.
However, if your MAGI surpasses those levels you may not be out of luck! That is because there are no restrictions on converting traditional IRA balances to a Roth and this fact birthed the backdoor Roth strategy.
A backdoor Roth contribution is a two-step process:
Make a non-deductible contribution of up to $6,000 to a traditional IRA (the maximum was $5,500 in 2018). In order to be eligible you must be younger than 70.5 and have earned income that is at least equal to your contribution amount. There is an exception for non-working spouses.
Convert the non-deductible contribution to a Roth IRA, which is essentially transferring the contribution from the traditional IRA to a Roth account. If you have no other funds in a pre-tax IRA, which includes SEPs and simple IRAs, the conversion has zero tax consequence.
If you do have a balance in a pre-tax IRA, a backdoor contribution gets complicated because of the pro-rata rule. The crux of the pro-rata rule is that a distribution from a non-Roth IRA must contain the same proportion of pre-tax and after-tax dollars as the account holder has across all of their non-Roth IRAs.
Here is an Example
Suppose Suzy has $54,000 in a rollover IRA that she funded last year from an old 401k plan. Suzy earns $400,000 annually so her friend Mary tells her that she should utilize a backdoor contribution strategy. Suzy takes Mary’s advice and makes a non-deductible contribution of $6,000 to a traditional IRA. Following that, she converts her $6,000 contribution into a Roth IRA that she opened years ago.
Suzy is under the assumption her conversion is exempt from tax, but since she has a balance in a pre-tax IRA, part of her conversion is taxable. At the time of conversion, 90% of her IRA funds were pre-tax. So, 10% of her conversion is tax-free and the remaining 90% is taxable. This is not a desirable outcome as Suzy is paying tax on her converted funds twice – the $6,000 she originally contributed was taxed as earned income and now she must report an additional $5,400 of income on her tax return.
One way Suzy could have avoided the pro-rata rule is by keeping her 401k balance with her prior employer. Or she could roll the balance into her new 401k plan. Especially since employer-sponsored retirement accounts, as well as inherited IRAs, are not subject to the IRA aggregation standards.
The backdoor Roth strategy was previously considered a loophole that potentially violated the step transaction doctrine. However, at the end of 2017, Congress blessed the backdoor Roth strategy cementing it as a legitimate method for higher income households to accumulate tax-free money over a lifetime!
Updated March 2019